How to Understand an Income Statement

Matt Quinn contributes to the Wall Street Journal's corporate finance blog. He has also written extensively about banking and corporate finance for publications including Inc., American Banker, and Financial Week. He lives in Brooklyn, New York.

7 COMMENTS

IMAGE:

iStock

Advertisement

Every business owner wants to know what the bottom line is. That all-important number is, of course, kept on the income statement. Though the income statement is simple enough on the surface, there's a lot more going on than just revenue less expenses equaling net income. And all income statements are not created equally.

Knowing how to read and analyze an income statement isn't just important for keeping tabs on your own company, but also sizing up the competition and even possible acquisitions.

To get the skinny on how a pro starts digging into an income statement, Inc.com spoke with Tom Robinson, the managing director of the education division of the CFA Institute in Charlottesville, Virginia. The institute is the gatekeeper of the Chartered Financial Analyst designation held many stock analysts and portfolio managers. Here's how Robinson gets going on an analysis.

Understanding an Income Statement: Keep an Eye on Cash Flow

The first thing Robinson says he does when he looks at an income statement is put it next to the cash flow statement. Simply put, the cash flow statement shows where you have cash coming in and going out over a certain period of time.

The reason you look at both is that you want to see if all that profit being shown is supported by cold hard cash coming into the company. Booming profits on the income statement and weak – or even negative – cash flows means that the quality of the earnings being shown isn't very strong and deeper analysis will likely be needed.

"If the company is a brand new start-up, it's not unusual to have positive, growing net income, and negative cash flow," Robinson says. The simple reason for that is a new, growing company will have to make substantial inventory investments and may not be collecting from its customers yet, creating a lag in receivables.

But for a more established company, cash flow and net income should be fairly highly correlated. "Once a company has matured, you should be receiving your cash from your old customers while you're selling to your new customers," Robinson says. "The cash flow should catch up."

We've already established that the revenue on the income statement doesn't necessarily represent the cash that's actually coming into the company, so you need to figure out how that revenue number is determined. To do that, you'll need to know what accounting methods were used. If a company uses the cash method of accounting, where income is only counted when cash is received, cash flow and revenue should be equal. But let's assume the accrual method is used due to either the company's size or the presence of inventory. Accounting rules allow for a lot of discretion under the accrual method, which means you have to watch out for those who really stretch them to make the numbers look better, Robinson warns.

The biggest area of concern is how the company recognizes revenue. That is, at what point during the sales process does it reflect revenue on its income statement? Most firms recognize revenue at the time of sale of a good or service. If that's the case, you need to know how they define a sale. Is it when they take an order? When they actually deliver a good? What if the company is having a hard time collecting their receivables? How do they record revenue for sales completed over a long period of time? Understanding how aggressive a company is in their revenue recognition helps you determine the quality of the numbers.

The same goes for expenses like depreciation and amortization. If the industry standard for depreciating an asset is 10 years, but the company spreads it out over 30, they're going to look more profitable until they have to replace that product.

In short, you need to identify the areas where a company has a lot of accounting discretion and figure out how aggressive or conservative it's being.

Step three for Robinson in looking at a company's earnings is performing a common-size analysis. That entails taking the income statements for the last three years and expressing all the expenses as a percentage of revenue for each year. The goal is to look for trends.

In a good scenario, revenue growth will outpace expense growth. Let's say in 2008, selling, general and administrative (SG&A) expenses account for 20 percent of all revenue. Then in 2009, when sales grew 25 percent, SG&A as a percentage of revenue is now 22 percent. The revenue growth is great, but it's being outpaced by expense growth. The common-size analysis let's you easily identify discrepancies that you'll want to explore further.

The fourth step is to compare the company's data to its peers. For small businesses, this can be an issue if they aren't competing with publicly traded companies. Even if they are, the comparison may not be a clean one. Robinson says there are some good sources of data for privately held companies, like Dun & Bradstreet and the Risk Management Association, formerly Robert Morris Associates, which puts out an annual financial statement study of small- and mid-size businesses. (If you don't want to shell out for these resources, check to see if your accountant gets them.)

Once you've obtained the data, you'll want to run through the same analysis you performed in the first three steps to see how they all stack up. How much is your company spending on SG&A compared to companies in your industry, not just in terms of total dollars, but as a percentage of revenue?

There are lots of ways to break down the information provided by an income statement. Three of the big profitability indicators you'll want to look at are gross profit margin, operating profit margin and net profit margin. Again, you'll want to look at all of them over a period of time to see how they're trending and figure out why they're going in a certain direction.

The gross profit margin is calculated by taking revenue minus cost of goods sold and then dividing that by revenue. "The gross margin is really a measure of how the company is doing at its most base level of activity," Robinson says. "Is it making a profit on the product it's selling?"

Next up is operating profit margin. Here you want to take revenue and subtract all the expenses related to the day-to-day operations of the business like cost of goods sold, labor and SG&A. This will exclude things like interest expense and one-time charges not core to your business operations. The result is your operating earnings, which you'll divide by revenue to get the operating profit margin. This gives you a sense of how the company is doing operating the business.

Finally, there's the net profit margin, which is the net income divided by revenue. It measures the amount of income a company generated for each dollar of revenue.

Of course, all of this becomes more complicated the bigger and more complex a business is. For example, conglomerate General Electric boasts five operating segments, all of which require their own financial breakdown, not to mention all the geographic regions.

But your business probably won't have to worry about all of that for, well, at least a couple more years.